Neo Material Technologies, the Canadian-headquartered producer, processor and developer of rare earths in China expects another boon year in 2011. As a reminder, rare earths are a strategic commodity for green technologies and other important sectors of the world economy. They constitute a multi-billion market in which demand is growing steadily. China has a near-monopoly (c 97% of rare earths production) and its export quotas are the key dynamic. A shortage of rare earths could delay growth of renewable technologies outside of China (e.g. high-efficiency electric motors, wind power turbines, some solar technologies).

Until late 2012 when Molycorp’s Mountain Pass mine is up and running, China alone will decide the supply and thus the pricing in the market. China adjusts its quotas twice annually (since 2007 when the adjustment of 1x/pa offered greater visibility). While the Chinese Ministry of Commerce claims to seek stability, international markets remain undersupplied and prices continue to soar.

In 2010 ROW consumption (measured by TREO, Industrial Minerals Company of Australia) was 52,500 tons when China’s export quota amounted to only 30,259 tons. The quota announced in January for H1 2011 (14,446 tons) is 35% less than in H1 2010 (22,283 tons) but nearly 50% higher than the stunningly insufficient amount for H2 2010 (only 7,976 tons). FY2011 ROW demand is forecast at 58,000 tons.

Reduced quotas are a mixed blessing for Neo Material Technologies but a net-net positive. On the one hand Neo Material Technologies exports less production from China and on the other hand it benefits from higher rare earth prices worldwide. Neo Material Technologies is fortunate to sell 51% of its revenue to a relatively stable market, domestic China where its relationships are long-standing.

Neo Material Technologies management made the following observations last week regarding its Q1 financial report:

It benefitted from the strength of the renmenbi against the dollar and an unprecedented increase in prices, two factors that underscore management’s upbeat view for the coming quarters

Despite the higher working capital costs required by much higher export duties for rare earths exported from China, Neo Material’s strong balance sheet can support this growth

The continued upward trend in consumer demand for electronic goods, renewable energy technologies, should keep prices firm in 2011. Supply restrictions will also contribute. The Chinese Ministry of Commerce implemented a further 4.5% cut in Chinese export quota in January. Speculation and inventory buildup may be accompanying this price inflation.

Geographically, demand within China is robust. The big surprise is Japan (Neo Material Technologies’ second biggest market, accounting for 17% of sales in H1) where demand has not slowed even in the Fukushima industrial neighborhood. This may be due to stockpiling by Japanese manufacturers. Management consider this so surprising they foresee some weakness in Japan to come.

While Neo Material Technologies sells only rare earths to China, it sells specialty metals globally and these are also performing well.

Management is actively searching for acquisitions. Rather than pay shareholders dividends it prefers to find M+A opportunities even in the current ‘hot’environment.

To end reliance on China, researchers are developing new materials that could either replace rare-earth minerals or decrease the need for them. But replacement materials and technologies may take years to develop. A successful example is Tesla’s induction motor which uses electromagnets rather than permanent rare-earth magnets to reduce the uncertain supply. GE Global Research hopes to demonstrate new magnet materials within the next two years.

Among them, Neo Materials has a particularly good track record, a strong balance sheet, hands-on experienced management with a vision to diversify away from China through expanding in areas such as specialty metals. Assuming specific company acquisition risk, industry risk inherent in a completely monopolistic industry and taking into account a strong management team and good visibility for growth in the coming quarters, the PE seems reasonable to us at around 10.5x 2011 EPS (estimated) and 9.7x 2012. We get to a target price of C$13 (+50%), a PE of 14x 2012 which is still cheaper than other peer strategic commodity mining companies.